We can never legislate or regulate our way to sustainable banking—the industry needs to adopt a new strategic business model
Déjà vu All Over Again
“They came on in the same old way and we sent then back in the same old way”.
They were the words the Duke of Wellington used to describe the repeated and futile attempts by Napoleon’s Grand Armée to break through the British defenses at Waterloo.
They can equally be used to describe the current prescriptions for the subprime crisis.
We remain mired in the unenviable position where those who know about banking are firmly wedded to the same old solutions, while those who don’t know about banking i.e. some in the mass media and certain politicians, resort to populist rhetoric. Sadly, the debate on the subprime crisis has generated more heat than light.
It is time for something different. However, before we move forward with a new prescription we need to better define the problem.
The Limitations of the Current Response to the Financial Crisis
Financial crises, and in particular banking related financial crisis, have been a regular feature of the past 40 years. They have included LDC debt, junk bonds, Savings & Loan, the Japanese asset bubble and the Dot-bombs. Each of these crises has been accompanies by the imposition of more legislation and more regulations on banks by governments and regulatory authorities. Not to be outdone, the banks themselves have on each occasion, implemented more governance and more internal controls.
These additional measures worked well—until of course the next crisis came along and more legislation, more regulation, more governance and more controls were put in place.
This does not mean that regulatory and governance frameworks do not need periodic updating. For example, the establishment of the Consumer Finance Protection Bureau (CFPB) in the US is a most welcome move. Safeguarding the public against predatory lending, which was a if not the primary cause of the subprime crisis, was long overdue. In reality, such legislation should have been put in place the day after the Pilgrim Father’s landed on Plymouth Sound—the natives would certainly not have minded.
However, we only have to look at the way banks, and investment banks in particular, are run and managed, in order to understand the limitations of an approach which is limited to the same old remedies.
The modern bank has an amazing number of control functions. They include external audit, internal audit, market risk management, credit risk management, operational risk, SOX (Sarbanes Oxley), finance, product control, change management, operations control, compliance and legal.
These all have their own significant limitations and challenges. I know this because I have worked in five of these functions and interacted closely with all the rest. The main problem is that they are not fully integrated. In a world which is both complex and dynamic this is a real concern and it should be no surprise that there is somewhat of a propensity for things to fall through the cracks.
However, the story does not end there. Overlaying all these functions is an array of committees. These might include Risk, Credit, New Product, ALCO (Asset and Liability), Operating and Product Pricing and Valuation.
Then of course there are the regulators. So for example if you are the London unit or branch of a US bank you not only have the Fed, SEC, OCC, CFTC, FDIC and CFPB to deal with, you also now have the UK regulatory authorities, the FSA and Bank of England, plus ruminations of the European Union.
So now we know what middle managers and senior executives of banks do during their working day. They have all developed a serious case of “meetingitis”. They drift like zombies all day long from one meeting to the next. The problem with that is that meetings are a great place for Groupthink; a practice where people collectively take decisions on important issues they would never have dreamed of taking, had they done an objective analysis on their own.
When one adds the complexity of products as well as the complexity of the IT and systems (such diagrams often look like a bowl of spaghetti) necessary to support said products then we should not be surprised that managing all of this is an extreme challenge.
This all leads us to another major limitation of traditional approaches. Major banking organizations have simply become too complex and management and governance alone are simply not enough to do the job.
The great irony of the financial crisis is that we blame the likes of Fred Goodwin, Dick Fuld and Stan O’Neal for leading RBS, Lehman’s and Merrill Lynch respectively to their demise—and rightly so. However, the truth is that the sheer size and complexity of their organizations was such that they were never really in control. Unfortunately, they were all unable to recognize the simple fact that they had all bitten off more than they could chew.
Therefore, we can only conclude that simply applying more of the same will not and cannot in the long run make our banks and banking systems any more sustainable. Yet, all is not lost. A more strategic and fundamental analysis of the subprime crisis and why banks really failed will assist us in determining what our response to the subprime crisis should be.
We will explore that more strategic and fundamental analysis in Part II. In the interim you can share your opinion on banks, values and the financial crisis by doing the Clearing The Bull survey using this link.